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Tuesday, 25 November 2014

The economics of carbon pricing 101: The carbon price and your electricity bill

The electricity market is a complex beast; people spend
their entire careers examining and analysing its inner workings. For most of
us, our only interaction with the market is through our electricity provider.
We get the monthly bill, try to pay it on time to get the prompt payment
discount, and receive a letter almost every year telling us that prices are,
surprise surprise, going up. We may occasionally ask ourselves “what’s happened
this time to make prices go up?” Usually the price increase is blamed on the
transmission companies, but since 2011 electricity prices have been influenced
by a new price – the price of carbon.

But just how does the price of carbon affect the price you
pay for the electricity you use? Two issues immediately come to mind when thinking
about the impact of the carbon price on residential electricity prices: the
‘peakiness’ of residential electricity demand, and uncertainty about the future
carbon price.

In 2013, households were responsible for about 32% of the electricity consumed in New Zealand. 75% of the electricity
generated in that year came from low-carbon renewable sources, mainly hydro.
That is surely more than enough to satisfy household electricity demand with
low-carbon electricity, minimising the exposure of households to the carbon
price. But the picture is a bit more complicated than that. One feature of
household electricity demand is that it is characterised by two large peaks. Most
household electricity is consumed during the hours of 6-9am and pm, basically
when people are getting up and getting ready for the day, and when people come
home and settle in for the night. Industrial demand, on the other hand, tends
to be more stable throughout the day. Most of the renewable generation capacity
is base capacity – the generation that is used to satisfy the more constant
part of electricity consumption. This is also the cheapest electricity to
supply, which is why base generation capacity is used first. To satisfy peak
demand, generators need to bring on additional generation capacity. The
marginal cost (the cost of producing an extra unit of electricity) for peak
generation is higher than for base generation; this is one reason why
residential electricity prices are higher than industrial prices. Peak
generation is also more carbon intensive, meaning that the carbon price has a
larger effect on the marginal cost of peak generation than base generation.
Economists consider a market to be operating efficiently if the price is equal
to the marginal cost of the last unit of output produced. For residential
electricity, the last unit of electricity is likely generated using the more
expensive and carbon intensive peak generation. If households are to face the
true marginal cost of the electricity they consume, then we would expect the
carbon price to have a larger effect on residential electricity prices. Note that this does not mean that all
household electricity needs to be priced at the high marginal price, but that
is a discussion for another article.

Electricity prices are set in advance for a lot of
residential contracts. Electricity companies have to set their price per kilowatt
hour on the basis of what they think certain costs will be, such as the
wholesale price, the distribution costs, and the carbon price. Companies have
some expectation of what these costs will be, and build these expectations into
the prices they set for the coming year. These expectations will very rarely be
100% accurate. With regards to the carbon price, some years it will be lower
than the companies expect, meaning that less is paid for the right to emit than
was thought. In other years, the opposite will occur. In years where the carbon
price turns out to be lower than expected, it can create the impression that
the electricity company is passing on a carbon price that is too high. But due
to the forward-looking nature of electricity prices, what is built in is what
the companies thought they would pay, which is unlikely to be what they
actually pay. As long as electricity companies form their expectations about
the future carbon price in a rational (taking into account all relevant
information available at the time) way, then on average they will pass on the
appropriate carbon price.

The whole point of a carbon price is to get people to take
the environmental cost of their economic decisions into account. Unfortunately,
it is not always obvious just how the carbon price is reflected in the prices
of things we buy – it’s just another price increase. This is particularly true
in complex markets like the market for electricity. Hopefully this piece has
provided some insight into the inner workings of the electricity market and how
the carbon price may be reflected in your electricity bill.

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What are New Zealand’s possible pathways toward a global low-emission future, and what important choices lie ahead? This blog creates a forum for sharing information and perspectives about the mitigation challenges that New Zealand faces, the assets that we have, the solutions that might be developed or adapted, the lessons we can learn from overseas and the experience that we can offer to other countries.

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